This invention relates to a method of and system for developing and continuously operating an automated, on-line risk transfer system.
Managing a business in a manner that creates long term value is a complex and time-consuming undertaking. This task is complicated by the fact that traditional financial systems do not provide sufficient information for managers in the Knowledge Economy to make the proper decisions. Many have noted that traditional accounting systems are driving modern managers to make the wrong decisions and the wrong investments. Accounting systems are “wrong” for several reasons. One of the most obvious reasons—they track tangible assets while ignoring intangible assets. Intangible assets such as the skills of the employees, intellectual property, business infrastructure, databases, management processes, relationships with customers and relationships with suppliers are not measured with current accounting systems. This oversight is critical because in the present economy the success of an enterprise is determined more by its ability to use its intangible assets than by its ability to amass and control the physical ones that are tracked by traditional accounting systems. The absence of intangible asset information is particularly notable in high technology companies that are highly valued for their intangible assets and their options to enter new markets.
Even when intangible assets have been considered in risk analysis, the limitations in the existing methodology have severely restricted the utility of the information that has been produced. All known prior efforts to value individual intangible assets have been restricted to independent valuations of different types of assets with only limited attempts to measure the actual impact of the asset on the enterprise that owns it. Some of the intangible assets that have been valued separately in this fashion are: brand names, customers and intellectual property. Problems associated with the known methods for valuing individual intangible assets include:                1. Interaction between intangible assets is ignored. For example, the value of a brand name is in part a function of the customers that use the product—the more prestigious the customers, the stronger the brand name. In a similar fashion the stronger the brand name, the more likely it will be that customers will stay a long time. Valuing either of these assets in isolation will not provide a meaningful valuation; and;        2. The value of an intangible asset is a function of the benefit that it provides the enterprise. Therefore, measuring the value of an intangible asset requires a method for measuring the actual impact of the asset on the enterprise—something that is missing from all known existing methods.        
Another aspect of the increasing importance of “intangible” assets is the fact that the primary risks faced by most companies have now shifted from hard asset damage (fire, flood, etc.) to soft asset impairment or loss. A recent study found that between June 1993 and May 1998, ten percent of the Fortune 1000 lost more than one quarter (25%) of their total shareholder value in one month. Almost two thirds of these “large losses” were caused by problems related to intangible assets.
The deficiencies of traditional accounting reports exacerbate the difficulty companies face when reporting problems with intangible assets because:                1. The absence of regular reporting means that all problems with intangible assets come “out of the blue”; and        2. The absence or regular reporting makes it difficult to monitor company efforts to correct the problems.        
Given the absence of reporting on many of the intangible assets driving the success of companies in the Knowledge Economy, it should not be surprising to learn that traditional accounting systems are also deficient in reporting significant information relevant to the liability side of the balance sheet. Traditional financial statements footnote or in some cases ignore large potential liabilities including: loss from litigation, environmental clean-up costs and shortfalls on leasing revenues. The absence of routine reporting on these risks does not alter the fact that they have a material, negative impact on the value of the company that has these risks. Recent studies completed at Oxford University have confirmed that “off balance sheet risk” has a negative impact on market value for firms that have these risks.
This negative impact of these risks on market value can be substantial. A recently completed study found that exposure to future, un-booked liabilities for environmental cleanup reduced share price by an average of 16% for electric utilities targeted by the Clean Air Act Amendments of 1990. It is worth noting that as more information became public regarding the actual cost of the environmental cleanup and pollution abatement the reduction in share price moderated. A transparent analysis of the liability associated with the environmental cleanup would have given the market the information required to more rapidly reach the proper conclusion regarding the impact of these new costs.
In addition to risks from intangible asset impairment and unrecognized liabilities, companies face other risks that are more readily analyzed. These risks are shown in Table 1.
TABLE 1Risks that are typically analyzed1. Foreign exchange risk;2. Interest rate risk;3. Portfolio risk;4. Credit risk; and5. Commodity price risk;These risks are usually analyzed using a standardized risk analysis product such as Dun and Bradstreet's Risk Assessment Manager™ for credit risk and Barra's Cosmos™ System for portfolio risk. The analyses of the risks listed in Table 1 are generally completed in isolation so their impact on the overall firm is not clear and opportunities for natural “self hedging” aren't apparent.
Another problem associated with developing risk programs for isolated assets is that they have generated severe losses for firms that didn't fully understand the potential liability their “risk reduction programs” were creating. One of the most common mechanisms for minimizing the risks shown in Table 1 is to hedge the exposure using a derivative or option to “lock in” the maximum amount of exposure the firm is faced with over a given time period. In some cases, when the risk factors moved in a direction opposite to the direction being hedged (i.e. interest rates dropped when they were expected to increase) the firm hedging its risk experience a far greater loss than any loss ever envisioned under the worst case analysis of their risk exposure.
Unexpected losses aren't the biggest shortcoming of traditional risk management systems. Because traditional risk management systems are driven by a statistical analysis of prior history, they are generally limited to dealing with events that vary within parameters that have already been experienced. The problem with this is that most large losses are caused by events that fall outside the bounds of normal experience (i.e. hundred-year floods and once-in-a-lifetime events).
It is also worth noting that the limitations of the general ledger accounting systems discussed previously (lack of information about intangible assets and off balance sheet risk) also extend to the risk analyses that are completed based largely on the information provided by general ledger systems. These same limitations also extend to the all known efforts to analyze and/or simulate the impact of changes in the business on financial performance and risk. Put simply—it is impossible to analyze the impact on risk with no prior information. The lack of detailed information on intangible assets and their impact on risk has also limited simulation products such as the Dynamic Financial Analysis (DFA) and the Small Business Financial Manager to projecting the impact of changes in revenue, expense or balance sheet items (tangible assets and financial liabilities) on financial performance. Given the growing importance of intangible assets to financial performance and risk, the utility of these systems is very limited. In a similar manner the lack of quantitative information on the impact of intangibles on financial performance has limited the usefulness of simulation products such as Tango that incorporate generic information regarding intangibles.
The complexity and relatively high cost of obtaining people that understand how to use the traditional risk analysis systems has generally limited the analysis and active management of risk to larger companies. This is ironic because large companies are the ones that are in the best position to absorb the risks that are being managed while smaller companies that don't have the resources to survive a large loss are left even more vulnerable by their inability to examine their risks in detail. Clearly, an automated system for developing comprehensive risk management programs for companies of all sizes would be beneficial.
However, even when comprehensive risk analyses are available the numerous coverage restrictions, general lack of precision in the policies and the high cost of traditional insurance dissuade many from obtaining the coverage that could, in some cases, save their companies from financial ruin. The multi-line, multi-period insurance policies some firms are selling only partially alleviate these problems. At the same time, the lack of precision in the risks being covered is understandable in so far as the insurers have only very limited information about the actual risks being faced by the companies they are insuring. A system that provided the insurers with continuous, detailed information regarding the risks faced by their clients would clearly help alleviate this problem.
Another barrier to effective use of insurance and risk reduction products like derivatives is the time required to analyze and purchase them. In some cases the need arises and disappears before the traditional systems and labor intensive review systems can respond. If the risk does not materialize, then everything is fine. If it does, then the company may go out of business before it faces the next risk. In either event, the large amount of time required to obtain these products leaves many companies exposed to risks that they could easily avoid if a more automated system was available.
The underlying cause of all these problems is that insurance and most financial services are delivered in a manner that is similar to the U.S. manufacturing sector twenty five years ago when obtaining the right product required an army of people to sift through a variety of quotes, place an order and then monitor the orders to make sure what was ordered actually arrived on time. The manufacturing and retail sectors have replaced their old, labor-intensive systems with electronic supply chain systems that tightly link them with their suppliers. Using these systems, suppliers provide the specific products and services that are required for smooth operation “just-in-time”. A similar system that would enable financial service firms to provide financial “products” like insurance, foreign exchange, capital and credit tailored to the specific situation on a “just-in-time” would clearly be beneficial. The system could also work in real time providing
One of the biggest problems with achieving this goal has been that there has been no agreed upon method for analyzing risk, liquidity and foreign exchange requirements and for communicating that information to financial service firms. It is worth noting at this point that while XML is widely touted as a panacea for inter-firm communication it is only useful in establishing the language for the communication—not the substance of what is being communicated. To satisfy all the potential providers of financial services, the substance of the communication regarding risk, liquidity and foreign exchange requirements would have to overcome the limitations of traditional systems that:
1) Ignore intangible assets;
2) Ignore real options;
3) Analyze individual assets in isolation, and
4) Ignore or footnote contingent liabilities and other off balance sheet risk;
In light of the preceding discussion, it is clear that it would be desirable to have an automated, real time system that could quantify and communicate information to financial service providers regarding the full spectrum of risk transfer (and liquidity) needs for an enterprise in a way that that was supported by a detailed, rigorous evaluation of all the elements of the enterprise that create business value and business risk. Ideally, this system would allow financial service firms to provide “just in time” and/or real time financial products and services in a manner that is customized to the exact needs of the enterprise using the system.